At Sears, Excessive Confidence Has a Price

In creating Sears Holdings, Edward Lampert used financial alchemy to produce gold from retail dross. But now he plans to cut costs, fire employees and sell real estate.

FLOYD NORRIS

Becoming very rich can show that you are a genius.

But thinking you are a genius can turn out to be a very expensive folly.

Perhaps Eddie Lampert, the 49-year-old hedge fund manager who fancied himself the next Warren Buffett, has figured that out by now. Whether or not he has, it may be too late for many of the quarter-million people who work for Sears and Kmart, not to mention for investors who believed the hype.

It was only five years ago that his genius became clear. He had used financial alchemy to produce gold from retail dross. He had taken control of Kmart as it emerged from a bankruptcy, and turned it into a valuable company. He had then taken over what had once been the greatest retail name in America — Sears. A merger of the two was to produce synergies and savings.

The new Kmart came out of bankruptcy in 2003 under his control — he had acquired debt in the company at low prices. Shares began trading at $15. By the time the company acquired Sears in 2005 and was renamed Sears Holdings, the price was above $130. It peaked at more than $190 in early 2007, on enthusiasm for the idea that Sears was sitting on a gold mine in real estate that could be turned into cash if the stores did not perform well.

Now we may find out if that theory will work. As an operating company, the new Sears is in trouble. So it plans to cut costs, fire employees and sell real estate. This week Sears reported that same-store sales for the last two months were down 5.2 percent from a year ago. There are a few weeks left before its fiscal year ends on Jan. 28, but Sears faces a stark reality: Retailers make all their money at Christmas. Or they don’t make money at all.

Through the years that Mr. Lampert dominated Sears as chairman and principal shareholder, he made it clear that he thought retailers worried too much about sales growth and not enough about profitability. He thought they spent too much money on fixing up their stores. He hired retail executives, then shoved them aside when they did not accept his wisdom. The current chief executive, Lou D’Ambrosio, had a long career at I.B.M. and ran Avaya, a technology company that went private during his tenure. Mr. D’Ambrosio never had any experience in retail before he was hired to run Sears.

Mr. Lampert declined to be interviewed this week. His last public comment on Sears seems to have come nearly a year ago, when he told shareholders the company’s “financial results remain at unacceptable levels.” They are much worse now.

When things were better, he wrote to investors more frequently. At the end of 2005, he explained why the rest of the industry was foolish:

“One subject where the conventional wisdom has been much on display recently is the issue of capital expenditures. As I made clear in my very first letter to shareholders, we do not subscribe to the view (seemingly widely held) that more is better, or that there is a certain amount that must be spent on cap ex every year. The question we ask at Sears (and I believe every business should ask) is: ‘What is the most productive way to allocate the capital that we have on hand and the cash flow the company generates?’ In some cases, spending money on the construction of new stores or the updating of existing stores produces real bottom-line benefits. In those cases, increasing capital expenditures is an attractive option. But if the analysis shows that allocating capital in some other way — for example, on acquisitions or stock repurchases — will generate superior returns, then it would be a mistake to plow money into capital expenditures merely because that is the ‘accepted practice’ or ‘expected.’ (That approach — of uncritically following accepted or prevailing practice — is what led many telecom companies astray as they tried to ‘keep up’ with WorldCom’s expenditure levels.)”

That comparison to WorldCom was telling. If he was going to seek out an example of the folly of following conventional wisdom, he might have tried to find one that did not involve fraud.

The problem that other companies faced was that WorldCom’s numbers were made up. It claimed to be making lots of capital investments in order to hide operating costs. Trying to match phony numbers was a recipe for frustration. But there is no reason to think that other retailers did not spend money on fixing up their stores to make them more attractive. They did, and customers noticed.

In letters to investors, Mr. Lampert told them to pay attention to earnings before depreciation charges, not to net earnings under normal accounting rules. That was a good idea, he said, because the depreciation expense reflected the excessive capital spending of the past, which would not be repeated.

By his preferred measure, the company now estimates that it will have a loss of a few hundred million dollars for the fiscal year ending in January. The net loss — the one using those pesky accounting rules — seems likely to be in the billions as the company takes lots of write-downs.

In the first few years of Mr. Lampert’s reign, the company did pay down debt. But more recently, it has been increasing its borrowing. To get by, it is going to have to borrow more.

On Thursday, Fitch cut Sears’s bond rating to CCC, the nether regions of junk. It warned that “there is a heightened risk of restructuring over the next 24 months.”

In Mr. Lampert’s 2005 letter, he pointed to two types of investment that might be superior to capital spending. One was acquisitions. The other was share repurchases. There is no doubt that he found the latter attractive.

From February 2005 through October of this year, Sears Holdings spent $6.1 billion on share repurchases, nearly double the $3.2 billion it spent on capital expenditures. Over the same period, depreciation expenses — a reflection of the old capital spending that Mr. Lampert deemed excessive — came to $6.6 billion.

I don’t know what would have been accomplished by spending more on capital expenditures, but it could not have been that much worse an investment than were the share repurchases. The company spent an average of $103.58 a share over the period, three times the current value of the shares, as it bought nearly 59 million shares.

Now Sears has 107 million shares outstanding, with a total market value of $3.6 billion.

It will be sad if Sears goes out of business, but there is precedent. Its predecessor as the No. 1 retailer in America, Montgomery Ward, lost that distinction because of a somewhat similar decision not to invest in its business. That came after World War II, when its chief executive, Sewell Avery, was sure a depression was coming and that he would be able to pick up the pieces when Sears went broke from building all those stores in the newly growing suburbs. It took decades for Montgomery Ward to vanish, but it eventually did.

This time, Mr. Lampert was sure that he knew better than all those retailers who believed that continued investment in facilities was necessary to avoid alienating customers and losing out to competitors.

To be fair, Mr. Lampert was no hypocrite. He does not seem to have sold stock when the company was buying, and it appears that the shares, which closed Thursday at $32.90, are still worth more than he paid. But his wealth — and that of investors in his hedge fund — has plunged. The winners were the former Sears shareholders who decided to take the company’s money and invest in some other company, perhaps one run by a boss who was less certain of his own brilliance.

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